Friday, April 18, 2014

Altria Group, Inc. (MO), through its subsidiaries, engages in the manufacture and sale of cigarettes, smokeless products, and wine in the United States and internationally. This dividend champion has managed to increase dividends to shareholders for 44 years in a row.

Many databases show reductions in dividend payments in 2007 and 2008, which is due to the spin-offs of Kraft Foods and Philip Morris International (PM). As a result, Altria was kicked out of what I used to believe was the elite dividend aristocrat index. The investors in Altria from early 2007 would have received shares in Kraft and Philip Morris International, and therefore their total dividend income would not have suffered at all. It actually increased, because all three companies raised dividends in 2008. Those original Kraft shares were further split into Mondelez International (MDLZ) and Kraft (KRFT). This is why one should not focus on purely quantitative characteristics, but also take the time to understand companies by analyzing them in detail one at a time. By focusing too much on screening, you might miss out on important information.

Since the spin-off of Philip Morris International in 2008, quarterly dividends per share have increased from 29 cents/share to 48 cents/share in 2013.

Altria Group pays a very high portion of net income as dividends to shareholders. However, it has limited needs to reinvest large portions of its net income, which is why this ratio is not as troubling as it would be for Coca-Cola (KO) for example. In the old days, Altria used its strong cash flows to diversify into food and spirits, but I do not think this is the case nowadays. Back until the early 2000s, Altria was known as Philip Morris. Now, it has a 26.90% economic and voting interest in SABMiller. Altria earned $402 million in dividends from its stake in SABMiller in 2012. It’s share of SABMiller’s profits was $1.224 billion. This stake is worth approximately 20 – 21 billion dollars at current prices. In comparison, Altria’s market capitalization today is $73 billion.

Earnings per share increased from $1.48 in 2008 to $2.26 by 2013. The company expects to earn $2.57/share by 2014 and $2.76/share by 2015. While I take forward analyst estimates with a grain of salt, I have a high degree of confidence that Altria can achieve decent earnings growth in the long-run, fueled by price increases which are higher than declines in volume and cost restructurings. This could translate into quarterly dividends hitting $2.05/share in 2014 and $2.20 in 2015.

Most know about the terrible facts about tobacco use. This has led to depressed valuations for tobacco companies in almost all of the times. This means that if you can reinvest those fat dividends at low valuations, your future returns have a very high chance of being pretty good.

Governments need tobacco companies, because it provides them with a healthy stream of revenues through excise taxes for example. Furthermore, it is much more popular to tax the evil tobacco conglomerates, rather than increase taxes on middle class voters, or reduce education expenditures for high-schools

The positives behind companies like Altria includes strong brand loyalty, the fact that consumers are addicted to the product, efficiencies of scale and strong pricing power. It would be almost impossible to start a competing tobacco company today, because of the ban on advertising.

Recent news about CVS (CVS) dropping tobacco products from its stores may have upset some investors, but those headlines are an example of investment noise out there. It is noise because consumers who were used to purchasing tobacco products at CVS would likely take their business elsewhere. Of course, the real risk is if other retailers follow suit, and decide to stop selling tobacco products altogether. I see this scenario having a very low likelihood however, since these retailers could lose out not only on tobacco revenues but on incremental revenues that tobacco customers bring with them. For example, if you buy your gasoline at the place that you also buy your pack of cigarettes, you might simply take all of your business elsewhere if your Marlborough is not available.

For Altria, it has a dominant position in the US tobacco market with Marlboro brand having a very loyal following amongst smokers. The sheer scale of operations allows Altria to exert higher influence on vendors and distributors. The company is also a leader in US the smokeless market, with a 50%-55% market share. The smokeless tobacco segment is expected to generate single digit volume growth.

Currently, this dividend champion sells for 16.10 times earnings, yields 5.30%, and has a high payout ratio. Given the economics of the business, and the expectation for future earnings growth in the mid single digits, I find it attractively valued today. I plan on adding to my position in the company sometime in 2014, subject to availability of funds.